The private equity owners of Mervyns have agreed to pay $166 million to settle their role in the retailer's bankruptcy.

In what could be a game-changing settlement for the private equity industry, three PE firms and several banks agreed to pay Mervyn's department store creditors $166 million to settle allegations that the firms took fraudulent profits and drove the retailer into bankruptcy four years ago.

After buying out the retailer from Target (TGT) in 2004 for $1.25 billion, the PE firms added roughly $800 million in debt, while paying themselves $200 million in fees and dividends between 2004 and 2006, according to bankruptcy court filings.

More egregious perhaps is how the firms profited from splitting Mervyn's into two businesses: a real estate firm and a retail chain that now had to pay rent at each of its location. That allowed the PE firms to quickly hike rents and pocket a nice profit.

"Who buys a company and then increases its rent? It was a shocking thing to watch," said Howard Davidowitz, chairman of the retail consulting firm and investment bank Davidowitz & Co.

Davidowitz said that by 2004, Mervyn's, once a well-liked discount retailer, was struggling but might have had a shot at a turnaround. "The private equity firms and the outrageous fees they took out were really the death knell for the company," he said.

Four years after the three PE firms bought Mervyn's, the department store's 175 locations were liquidated and 18,000 people lost their jobs.

The financial crisis of course exacerbated the woes of many troubled companies. Mervyn's was just one among a number of private equity-owned retailers that ended up in bankruptcy during the crisis. Linens N Things, KB Toys, Steve & Barry's were among the others. Yet it's one of the few situations where private equity firms have paid for their alleged errors, and it's by far one of the largest such settlements.

None of the parties admitted or denied any wrongdoing, yet the sheer size of the settlement is already raising questions throughout an industry that's come under so much scrutiny during the Presidential campaign.

"This settlement is very unusual," said William Birdthistle, a professor at the Chicago-Kent School of Law, who has published studies on potential conflicts of interest in private equity buyouts. "A lot of what the private equity industry does to a company is very unsavory but these firms generally know how to extract every possible dollar in a legal way."

Banks that helped finance the buyout, including Goldman Sachs (GS), RBS (RBS) and Citigroup (C) are also paying into the settlement, according to documents filed with the U.S. Bankruptcy Court in Delaware.

"This settlement makes it seem like the cultural winds have shifted so much for the industry that firms are worried about what would have happened if they had gone to trial," said Birdthistle.

Cerberus, for example, gained notoriety during the financial crisis because two companies it partly owned, Chrysler and General Motor's (GM) financing arm GMAC, were bailed out by the Treasury Department.

And in this case, the bankruptcy documents show just how far the private equity firms and their lenders will go to keep this settlement out of the spotlight.

The documents specify that the creditors cannot mention any of the firms involved in the settlement in "any press release, public filing, website positing or other public announcement."

If that's not keeping the creditors quiet enough, the terms of the deal also state that the creditors and its lawyers can't mention the names of the PE firms in "any mass or targeted mailings" or "on panels for or with colleagues to any group in excess of 100 people."

None of the private equity firms returned calls for comment. Cooley, the lawyers for the creditors, also declined to comment.